Federal Income Tax on Timber

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1 United States Department of Agriculture Forest Service Southern Region R8-TP 39 Revised November 2011 Third Edition 2011 Federal Income Tax on Timber A Key to Your Most Revised by Linda Wang USDA Forest Service Reviewed by William C. Siegel Attorney-at-Law

2 A Key to Your Most R8-TP 39 Revised November 2011 Revised by Linda Wang, Ph.D. National Timber Tax Specialist, USDA Forest Service Reviewed by William C. Siegel, J.D. Attorney, River Ridge, Louisiana

3 Disclaimer This publication is intended to be used solely for educational purposes. The materials contained herein are not legal or accounting advice and should not be construed as such. Consult your professional legal or tax advisors for your specific tax situation. Pursuant to the IRS Circular 230 rules, any U.S. federal tax advice contained here is not intended or written to be used for the purpose of avoiding penalties under federal tax law, or promoting, marketing, or recommending to another party any transaction or matter addressed herein. The U.S. Department of Agriculture (USDA) prohibits discrimination in all its programs and activities on the basis of race, color, national origin, age, disability, and where applicable, sex, marital status, familial status, parental status, religion, sexual orientation, genetic information, political beliefs, reprisal, or because all or a part of an individual s income is derived from any public assistance program. (Not all prohibited bases apply to allprograms.) Persons with disabilities who require alternative means for communication of program information (Braille, large print, audiotape, etc.) should contact USDA s TARGET Center at (202) (voice and TDD). To file a complaint of discrimination write to USDA, Director, Office of Civil Rights, 1400 Independence Avenue, S.W., Washington, D.C or call (800) (voice) or (202) (TDD). USDA is an equal opportunity provider and employer.

4 INTRODUCTION 2011 Edition This publication provides a quick reference on timber tax laws that are important to woodland owners. It presents a concise and easy-to-understand explanation of the most commonly asked tax questions. The intended audience includes consulting foresters, woodland owners and loggers who need a basic understanding of federal income tax rules on the management of woodland property. It is also a valuable resource for tax practitioners: CPAs, tax managers, enrolled agents, attorneys, and tax return preparers who seek a quick overview of timber tax rules. Since the first income tax Form 1040 appeared in 1913, many timber tax provisions have been added to encourage management and stewardship of private woodland that are commonly unknown by tax professionals. This publication is prepared to help woodland taxpayers and their professional advisors to learn and utilize these tax laws. Please send any comments on this publication to: Linda Wang, USDA Forest Service Williams Siegel, Attorney-at-Law

5 Contents I. Your Woodland Tax Classification Personal Property Investment (Income-Producing) Property Business Property ) Business or Hobby ) Passive Activity... 4 II. Timber Sales If Your Woodland Property Is an Investment If Your Woodland Property Is a Business ) Sale of Standing Timber (Section 631(b)) ) Sale of Cut Timber (Section 631(a)) Farming and Timber Expenses of Sale Installment Sale III. Capital Asset and Cost Recovery Timber Basis ) Basis of Purchased Timber ) Basis of Inherited Timber ) Basis of Gifted Timber Reforestation Costs Timber Depletion Deduction Depreciation, Section 179 Expensing, and Special (Bonus) Depreciation IV. Expenses of Woodland Management and Protection Woodland as an Investment Woodland as a Business V. Cost-Share Payment Tax Treatment in General Exclusion from Income VI. Timber Losses Casualty Loss Theft Loss Condemnation VII. Form T More Information... 25

6 I. YOUR WOODLAND TAX CLASSIFICATION 1. PERSONAL PROPERTY Type of Activity Your woodland property may be taxed under one of three tax classifications: personal property, investment (income-producing) property, or business property. The tax rules vary considerably with each classification. You must determine your property's tax classification for each tax year. The determining factors for your woodland property's tax classification depend on why you own the property, your use of it, and your activities on it. Woodland property not used to produce income may be classified as being held for personal use. For example, your primary purpose for owning the property may be for personal enjoyment, such as for a family retreat or for personal hunting and fishing, rather than for making a profit. There are tax disadvantages for personal property: losses on the sale of personal property are generally not deductible except as casualty loss as a result of fire or storm damages or theft. Gains from sale of personal property are taxed as capital gains (IRS Publication 544). Use Form 1040 Schedule D and the new Form 8949 to report capital gains from sale or exchange of personal property. The adjusted basis of personal property is the original cost or other value of the property as determined under the tax law, adjusted for subsequent changes (see pages 11 through 13 for a discussion of basis ). The amount of capital gains from sales of personal property is determined by subtracting the property's adjusted basis and selling expenses from the gross sale proceeds. 1

7 I. YOUR WOODLAND TAX CLASSIFICATION 2. INVESTMENT (INCOME-PRODUCING) PROPERTY Types of Activity Woodland property held for incomeproducing purpose may be an investment when your activity does not rise to the level of a trade or business. Sales of standing timber held as an investment are taxed as capital gains. Capital gains are defined as either longterm or short-term gains. If you owned your timber for 1 year or less, the capital gains from your timber sale are short-term; if you owned your timber for longer than 1 year, the capital gains from your timber sale are long-term. Expenses for woodland held as an investment are deductible, but such deductions (together with other miscellaneous itemized deductions) are subject to 2% of your adjusted gross income floor (see page 17). Only the excess amount over the 2% floor is deductible. (This limitation is a disadvantage when compared to deductions allowed under the business classification see next page in which all expenses are deductible, though other restrictions also apply.) Best Tax Treatment You must have a profit objective to claim an investment status for your woodland. One of the best ways to document a profit objective is by including income production in your woodland management plan. Timber owned primarily for generating profit may be classified as either an investment or business property. The distinction between an investment and business is based on specific circumstances. If your acreage is relatively "small" with infrequent sales transactions, you may prefer to claim the investment status for simplicity of filing. Use Form 1040 Schedule D and the new Form 8949 to report gains from sales of standing timber held as an investment. It's prudent to file Form T (Timber), Forest Activities Schedule, if you claim a deduction for depletion of timber (see page 15). Timber management expenses for woodland held as investment are reported on Form 1040 Schedule A (see page 17). 2

8 I. YOUR WOODLAND TAX CLASSIFICATION 3. BUSINESS PROPERTY 1) Business or Hobby Types of Activity A business is an activity you regularly and continuously engage in primarily to make a profit. Although both investment status and business status require clear for-profit objectives, a business carries out timber activities on a more regular, active, and continuous basis than an investment. Which status applies depends on the specifics of each case. If the profit objective is not met, your activity may be considered a hobby rather than a business. Losses that are deductible for a business are not allowed for a hobby. Best Tax Treatment Business or Hobby. The IRS lists a set of factors to determine "profit" from an activity: Does the time and effort you put into the activity indicate an intention to make a profit? Do you depend on income from the activity? If there are losses, are they due to circumstances beyond your control or the start-up phase of the business? Have you changed methods of operation to improve profitability? Do you and your advisors have the knowledge needed to carry on the activity as a successful business? Have you made a profit in similar activities in the past? Does the activity make a profit in some years? Can you expect to make a profit in the future from the appreciation of assets used in the activity? The IRS presumes a profit motive if you show a profit in at least 3 of the last 5 years. Such "profit" includes the appreciation of asset, which is more relevant for the case of timber. You may have to prove a for-profit intent in case of an IRS audit. One of the best ways to document a profit objective is by including income generation in your woodland management plan. Business. Use Form 4797 and Form 1040 Schedule D for qualified sale of standing timber (Section 631(b)) (see page 6). For sale of cut timber, if elected, report qualified capital gains portion on Form 4979 and Form 1040 Schedule D, and the ordinary income portion on Form 1040 Schedule C (Section 631(a)) (see page 7). The woodland management expenses are deductible on Form 1040 Schedule C (see page 18). Hobby. Income from a hobby activity is taxable as "other income" on Form Hobby expenses, deductible up to hobby income, are reported on Form 1040 Schedule A. Hobby losses are generally not deductible. 3

9 I. YOUR WOODLAND TAX CLASSIFICATION 3. BUSINESS PROPERTY 2) Passive Activity Types of Activity Your timber activity may be a business if you regularly and continuously engage in it primarily to earn a profit. Your participation in the business may be active or passive. To be actively engaged in business, you must "materially participate" in the business activity; otherwise, your participation may be a "passive" activity. For passive activities, the deduction of a business loss (expenses exceeding income) is restricted: loss from passive activity cannot offset income from non-passive activity (such as retirement income, salary, or self-employment income). You can carry the unused losses over into future years. The passive loss rules apply to individuals, partners, and members of LLCs, S corporation interests, estates, and trusts. Note: Generally, woodland held as investment is not subject to the passive loss rules. Best Tax Treatment "Material participation" in the business may help avoid passive loss restrictions. To materially participate, your involvement must be "regular, continuous, and substantial. If you meet at least one of the following tests, you are considered a material participant in your business: You participate in the activity for more than 500 hours during the tax year; Your participation constitutes substantially all of the involvement in the activity during the tax year; You participate for more than 100 hours in the activity during the tax year and no other individual participates more; Your participation in all of your "significant participation" businesses, including timber, exceeds 500 hours for the tax year (a "significant participation" activity is defined as a trade or business in which you participate for more than 100 hours); You materially participated in the activity for at least 5 of the preceding 10 tax years; or All facts and circumstances indicate material participation (a minimum of 100 hours is required). Passive business losses are computed on Form Keep records on the time you spend in managing your property to support your participation in the woodland business. Material participation must be established on an annual basis. 4

10 II. TIMBER SALES 1. IF YOUR WOODLAND PROPERTY IS AN INVESTMENT Types of Forest Activity If your timber is an investment, your standing timber sales are capital gains rather than ordinary income. Long-term capital gains are advantageous: They are taxed at lower rates than ordinary income. (In 2011, the maximum rate for long-term capital gain is 15% while the maximum rate for ordinary income is 35%.) They are not subject to selfemployment tax (as ordinary business income is) except for gains from sale of property by passive business (which will be subject to a 3.8-percent Medicare tax starting in 2013 if the taxpayer s individual adjusted gross income is over $200,000 or $250,000 for a married filing jointly). They do not adversely affect your social security payments at retirement. Capital losses can offset capital gains in full as well as $3,000 ordinary income each tax year. Short-term capital gains are taxed at ordinary income tax rates. For sales to qualify for long-term capital gains, you must hold the investment timber * for longer than 1 year prior to the sale. If you receive the property as a gift and your basis is the donor s basis (see page 13), both the donor s and your holding periods may be counted together as your holding period (IRS Publication 544). If the recipient s basis is the fair market value of the property, the recipient s holding period starts after the date of gift (IRS Publication 17). If you inherit the property, your timber is considered long-term. * The term timber includes evergreen trees that are more than 6 years old when severed from their roots and sold for ornamental purpose, such as Christmas trees. Capital gains from sales of standing timber held as investment are reported on Form 1040 Schedule D and the new Form It's prudent to file Form T (Timber), Forest Activities Schedule, if you claim a deduction for depletion of timber (see page 15). The amount of capital gains is determined by subtracting the timber s adjusted basis (pages 11 to 13) (through depletion) (see page 15) and selling expenses from the gross sale proceeds. You sold 100 thousand board feet (Doyle scale) of southern loblolly pine sawtimber for $30,000 in The selling expenses totaled $4,500. You bought the timber in 2002 for $15,000 as an investment. Your taxable capital gains are $10,500 ($30,000 - $4,500 - $15,000). Since you owned the property for more than 1 year, the $10,500 capital gains are long-term. Report the sale on Form 1040 Schedule D and the new Form Since you claim a $15,000 (depletion) deduction, it's prudent to complete and attach Form T (Part II and Part III) to your return. 5

11 II. TIMBER SALES 2. IF YOUR WOODLAND PROPERTY IS A BUSINESS 1) Sale of Standing Timber (Section 631(b)) Qualified sales of standing timber * by a woodland business may be taxed as longterm capital gains (Section 1231 gains). This includes both lump-sum and pay-ascut standing timber sales. A lump-sum sale is an outright sale of standing timber for a fixed total amount agreed upon in advance. Under a pay-as-cut contract, the timber purchaser pays the seller at a specified rate per unit of timber actually cut. The seller bears the risk of loss until the timber is cut. The advantages of long-term capital gains are on page 5. To be eligible for long-term capital gains (Section 1231 gains), you must be the owner of standing timber (including a sublessor of timber or the holder of a contract to cut the timber) for longer than 1 year in a trade or business. Effective after December 31, 2004, outright sales of standing timber, as well as pay-as-cut sales, by a timber business qualifies for long-term capital gains if the timber is held for more than 1 year (as amended by the American Jobs Creation Act of 2004). Historic note: Prior to 2005, timber business owner had to sell the standing timber by a pay-as-cut contract ( retained economic interests ) to qualify for capital gains treatment. The gain or loss of the standing timber sale in a business is the difference between the sale proceeds and the timber s adjusted basis (see pages 11 to 13) (through depletion) (see page 15) and sales expenses. Use Form 4797 and Form 1040 Schedule D to report the standing timber sale in a business. Also it's prudent to file Parts II and III of Form T (Timber), Forest Activities Schedule (see "Form T" on page 24) when you claim a deduction for depletion of timber (see page 15) or make an outright sale of timber in a trade or business. * The term timber includes evergreen trees that are more than 6 years old when severed from their roots and sold for ornamental purpose, such as Christmas trees. You run a timber-growing business. The highest bid for your standing timber by a logger was $40,000, and you accepted this offer. The adjusted basis of the timber was $5,000 and your selling expenses were $6,000. Since the timber is a property in your timber business for more than one year, the standing timber sale qualifies for long-term capital gains (Section 631(b)). Your taxable capital gains of $29,000 ($40,000 - $6,000 - $5,000) are reported on Form 4797, and Form 1040 Schedule D. It's prudent to file Form T (Parts II and III). 6

12 II. TIMBER SALES 2. IF YOUR WOODLAND PROPERTY IS A BUSINESS 2) Sale of Cut Timber (Section 631(a)) MAKING SEC. 631(a) ELECTION On Form T, Part II (Timber Depletion), Line 18, Section 631(a): A. Are you electing, or have you made an election in a prior tax year that is, in effect, to report gains or losses from the cutting of timber under section 631(a)? (see instructions). Yes Instead of selling standing timber, timber business owners can cut the standing timber themselves or have their standing timber cut for them and then sell the cut timber products or use the timber in their businesses. This type of sale differs from standing timber sale in that it has two parts for tax purposes: standing timber disposal, if elected, and cut timber sale. All gains are ordinary income unless an election is made to treat standing timber cutting as a sale to qualify for capital gains (known as Section 631(a) election). See the advantages of long-term capital gains on page 5. No To qualify for capital gains (Section 1231 gains) for the cutting of standing timber *, you must own or hold the contractual right to cut timber for longer than 1 year before it is cut. The timber must be cut for sale or for use in your business. Timber held for less than 1 year is not eligible. And you must make a (Section 631(a)) election on Form T (Timber), Forest Activities Schedules (see page 24). The capital gains from standing timber cutting is the difference between its fair market value (FMV) on the first day of the tax year in which it is cut and its adjusted basis (see "basis" on pages 11 to 13 and "depletion" on page 15). The ordinary income from sale of cut timber is the difference between sale price and the FMV of standing timber on the first day of the tax year in which it is cut minus cut-n-haul expenses. *The term timber includes evergreen trees that are more than 6 years old when severed from their roots and sold for ornamental purpose, such as Christmas trees. For qualified timber, make the election for the year the timber cutting takes place on Line 18, Part II of Form T. No election is allowed on an amended return (Section (c)). Report the capital gains portion on Form 4797 and Form 1040 Schedule D. Report ordinary income on the sales of cut timber on Form 1040 Schedule C. File Form T when you make a Section 631(a) sale. You hired a logger who cut standing timber held longer than 1 year in your woodland business and hauled it to a local paper mill and sold it at $103/cord. It had an adjusted basis of $10/cord. The FMV of the standing timber on January 1 was $26/cord. The cut-n-haul cost was $67.5/cord. Without a Section 631(a) election, the entire gains of $25.5/cord is ordinary income ($103 - $ $10). Under Section 631(a) election, gains of $16/cord ($26 - $10) from standing timber cutting are capital gains. The rest of $9.5/cord gains ($103 - $ $26) from sale of cut timber is ordinary business income. 7

13 II. TIMBER SALES 3. FARMING AND TIMBER Woodland owners may own farmland and engage in farming operations. Farmers may own timber, either as a minor part of their farming business or as a separate timber operation. Generally growing timber is not treated as part of the business of farming for many income tax provisions, such as expensing of water and soil conservation costs and endangered species recovery costs (total deduction of such expenses are limited to 25% of gross income from farming) and income averaging for qualified farmers. Standing timber sales may be capital gains (provided they meet the requirements, see pages 5 to 7) while sales of farm crops are generally ordinary business income. You are in the business of "farming" if you cultivate, operate, or manage a farm for profit, including livestock, dairy, poultry, fish, fruit, and truck farms" as well as "plantations, ranches, ranges, and orchards (IRS Publication 225). This definition typically does not include timber. The tax rules for timber sales (see pages 5 to 7) apply to farmers who also own timber. Qualified reforestation costs may be deducted and amortized by a woodland owner and a farmer (see page 14). A farmer may expense tree planting costs under the Conservation Reserve Program along with water and soil conservation expenses up to 25% of gross farming income. This excludes woodland owners. Use Form 1040 Schedule F to report farming income and expenses, including minor sales of logs, firewood, or pulpwood if timber is a minor part of your farming operation. Use Form 1040 Schedule D and Form 8949 to report sale of standing timber owned as capital asset (see page 1 and 5) by a woodland owner or a farmer who also owns timber. Report investment timber expenses on Form 1040 Schedule A (see page 17). Use Form 4797 and Form 1040 Schedule D to report qualified capital gains for timber business (see pages 6 and 7). Report timber business expenses on Form 1040 Schedule C (see page 18). 8

14 II. TIMBER SALES 4. EXPENSES OF SALE Timber sale expenses are the costs incurred directly from the sale of timber, such as: the costs of advertising; timber cruising (to determine timber volume); overnight travel (excluding commuting expenses); marking for harvesting; scaling (measurement of products); legal fees; and fees paid to consulting foresters Timber sale expenses are fully deductible from the sale proceeds. To support your timber sale expenses, adequate records must be maintained. This include receipts, bank statements, canceled checks, financial statements, invoices, mill scale slips, closing statements, 1099-S forms (reporting gross sale proceeds paid to you for the sale of your timber), sales contracts, and forest management plans to support the deduction. You sold hardwood sawtimber for $8,000. Its adjusted basis was $1,000. You paid $800 to a consulting forester handling the sales. Your timber is an investment. Sale price $8,000 - Selling expenses $800 - Adjusted basis ("depletion"): $1,000 Gains $6,200 You report the sale expenses on the new Form 8949 and Form 1040 Schedule D. It is prudent to file Form T (see page 24). If your timber holding is an investment, timber sale expenses are reported on the new Form 8949 and Form 1040 Schedule D (see page 5). If your timber is a business, standing timber sales and the sales expenses are reported on Form 4797 and Form 1040 Schedule D (see page 6). For business owners who elect to treat timber cutting as sale under Section 631(a), the timber sale and sale expenses are reported on Form 4797 and Form 1040 Schedule D and Schedule C (see page 7). 9

15 II. TIMBER SALE 5. INSTALLMENT SALE An installment sale is a sale in which you receive one or more payments in a tax year after the year of timber sale rather than in full in the year of sale. An installment sale may allow you to defer tax and spread the gain over the installment payment periods; otherwise, you must pay taxes on the entire gains in the year of timber sale. In 2011, you sold $20,000 of timber, realizing a profit of $18,000. You took a note payable in March The sale is considered an installment sale because you receive one payment in the tax year after the year of sale. So you report the gain in 2012 on Form You may elect not to use the installment method on your timber sale if you want to report the $18,000 gain in 2011, the year of timber sale. If you receive sale proceeds after the year of sale, you must use the installment sale reporting. You may, however, elect not to use the installment sales by reporting the entire profit in the year of sale, even though you will not be paid for all of the sale proceeds until later. Interest is generally charged on deferred payments. If interest is not charged, a portion of the payment must generally be calculated as (imputed) interest. Installment sales generally do not apply to pay-as-cut contracts (even with "a retained economic interest") by the IRS regulation. For each year that you receive installment payments, report the gain on Form The gain is then transferred to Form 1040 Schedule D for investment timber and Form 4797 for business timber. Form T (Timber), Forest Activities Schedule, may also be required (see page 24). Interest payments you receive on the installments are reported as ordinary income. You can elect out of installment sale by including the entire gains on Form 1040 Schedule D or Form In 2011, you sold timber for $10,000 that you bought in 2000 for $4,000. Selling expenses were $1,000. You are to receive installment payments of $2,000 in 2011 and 2012 and $6,000 in 2013, plus interest. Your gross profit is $5,000 ($10,000 - $4,000 - $1,000). Your gross profit percentage is 50% ($5,000 profit / $10,000 contract price). You file Form 6252 to report the gains of $1,000 (50% x $2,000 installment) in 2011 and 2012 and $3,000 (50% x $6,000) for The interest payments are separately reported as ordinary income. 10

16 III. CAPITAL ASSET AND COST RECOVERY 1. TIMBER BASIS 1) Basis of Purchased Timber Basis of purchased timber is its purchase cost. Documenting the timber basis is beneficial because: 1) it reduces timber sale proceeds and thus reduces your taxes on timber sale; 2) allows you to claim loss deduction if your timber is lost, damaged, or destroyed by casualty, theft, condemnation; and 3) it allows you to recover the costs of reforestation that you may incur. The cost of woodland purchase should be allocated among the capital assets acquired, such as land, timber, and other property, based on its relative share of their fair market value. The best time to establish the original basis of your timber is at the time of acquisition because the timber volume and value may be readily available then. Retroactively determining timber basis may be acceptable but the cost of doing so should be weighed against any potential tax savings. The basis of purchased timber includes the purchase price of the timber and other acquisition costs, such as legal fees, accounting fees, title search, and consulting forester s fees. Document your timber basis in premerchantable timber and merchantable timber categories (such as sawtimber, pulpwood, etc.). Include both timber volume and value in the basis. The original basis of timber may change over time by adjustments, such as new purchase, timber growth, timber loss or sale. The adjusted basis of timber is used to determine the gains or losses of timber sale, casualty, theft loss of timber, or condemnation. Document and report the original basis of timber in Form T (Timber), Forest Activities Schedule, Part I. If you are not required to file Form T, you should keep it as part of your records (see page 24). Subsequent adjustments to timber basis, such as timber growth and recovery of basis from timber sale, are made in Part II of Form T. The tract of woodland next to your property was appraised at $40,000 ($10,000 for the land itself and $30,000 for 3,000 cords of pulpwood timber on it). You purchased it for a total of $38,000. The seller gave you $2,000 discount because you paid in full by cash. You spent $200 in title search and $800 for consulting forester s fees. So your total cost was 39,000 ($38,000 + $200 + $800), which should be allocated between land and pulpwood timber in proportion to their fair market value. The land s basis is $9,750 ($39,000 x $10,000/$40,000) and the pulpwood s basis is $29,250 ($39,000 x $30,000/$40,000). 11

17 III. CAPITAL ASSET AND COST RECOVERY 1. TIMBER BASIS 2) Basis of Inherited Timber The basis of inherited timber is the fair market value of the timber on the date of the decedent s death ("stepped-up" basis) or the value on the alternate valuation date (6 months after the date of death). There is another option for 2010 decedents. An election allows a limited stepped-up basis, but the estate tax is eliminated entirely, regardless of the size of the estate. Such limit is $3 million if passed to spouse, plus an additional $1.3 million to any other heirs. The basis of an inherited property under the special use valuation (of Section 2032A) is the value under such method. Your basis of land, timber, and other capital assets must be separately established. See page 11 for retroactive determination of timber basis and the advantage of establishing basis. See IRS Publication 4895, Tax Treatment of Property Acquired From a Decedent Dying in Establishing timber basis requires a determination of the timber volume and value on the date of the decedent s death. The basis is set up by timber account (or "block" typically by large commercial landowners): for example, an area within geographic boundaries, political boundaries, or management units. Keep track of timber volume as part of the timber basis. Retain records to verify your timber basis computations. Document the original basis of timber on Form T (Timber), Forest Activities Schedule, Part I. If you are not required to file Form T, prepare and keep it as part of your records (see page 24). Subsequent adjustments to timber basis, such as timber growth and recovery of basis from timber sale, are made on Form T, Part II. For 2010 decedents, the estate must elect on Form 8939 by January 17, 2012 to use the limited stepped-up basis (this option avoids the estate tax entirely). On June 2, 1998, you inherited the woodland that has been kept in the family for generations. In 2011, you had a timber sale. Your tax preparer asked your timber s adjusted basis to file your tax return. You didn t establish the timber basis at the time of inheritance. But your forester was able to provide a professional report that established the timber volume and fair market value on the date of the decedent s death: 800 cords of pulpwood at $15 per cord. So your timber basis is $12,000 ($15 x 800 cords). Properly setting up timber basis saves taxes from the timber sales. 12

18 III. CAPITAL ASSET AND COST RECOVERY 1. TIMBER BASIS 3) Basis of Gifted Timber If the fair market value (FMV) of the timber at the time of the gift is equal or more than the donor s adjusted basis, your timber basis is the donor s adjusted basis. Gift taxes paid by the donor may increase your basis by all or a portion of it depending on the date of the gift. If the timber's FMV at the time of the gift is less than the donor s adjusted basis, your basis is: 1) the donor s adjusted basis for figuring gain when you later dispose it; 2) the FMV on the date of gift for figuring loss from the sale. You may have neither a gain nor loss from sale of gifted timber if you sell for more than the FMV but not more than the donor s adjusted basis. See the benefits of establishing basis on page 11. Also see the explanation of retroactive determination of timber basis on page 11. To determine the basis of gifted timber, you need to know the donor's basis, the FMV at the time of the gift, and gift taxes paid, if there were any. Establishing the original basis of timber at the time of gift saves time and money because timber value and volume information may be readily available. In 1999 your father transferred title to you, as a gift, a 49.5-acre woodland that had timber with a fair market value (FMV) of $16,000. His timber basis was $2,000. Since the FMV of timber of $16,000 is more than your father s adjusted basis of $2,000, your original basis for the timber was $2,000, the donor s basis. Document and report the original basis of timber in Form T (Timber), Forest Activities Schedule, Part I. If you are not required to file Form T, you should keep it as part of your records (see page 24). Subsequent adjustments to timber basis, such as timber growth and recovery of basis from timber sale are made on Form T, Part II. 13

19 III. CAPITAL ASSET AND COST RECOVERY 2. REFORESTATION COSTS Reforestation costs include site preparation, seedlings, labors, tools, consulting forester's fee, and depreciation on equipment used in planting and seeding. It also includes post-establishment brush control to ensure the survival of the stands. To recover the reforestation costs incurred after October 22, 2004: up to $10,000 per year ($5,000 if married filing separately) may be expensed in the year of reforestation per qualified timber property. Any excess amount over the $10,000 may be deducted ("amortized") over an 84- month period: in the year of reforestation, you can deduct 1/14 th of the excess costs. In the 2nd-7th years, 1/7 th of the excess costs are deducted, and in the 8 th year, the final 1/14 th is deducted. The $10,000 expensing was increased to be $20,000 per eligible property in the Gulf Opportunity Zone for timber owners with no more than 500 acres, effective August 27, 2005 through the end of Trusts, publicly traded C-corporations, and real estate investment trusts do not qualify. Historic note: The 10% investment tax credit (applicable for reforestation prior to October 23, 2004) was no longer available after October 22, Qualified expenditure is direct costs incurred to establish commercial timber stands. "Qualified timber property" means a woodlot located in the United States that will contain trees in significant commercial quantities. Both natural and artificial regeneration qualify. Individuals, estates, partnerships, and corporations are eligible for both the $10,000 reforestation expensing and the amortization provisions. Trusts are only eligible for the amortization provision. Reforestation must be kept separately from other timber account that is allowed for depletion or casualty loss. Reforesting your timber tract cost you $12,000 in You can deduct $10,000 outright in Of the remainder, you can elect to deduct (amortize) $143 in 2011 (($12,000 - $10,000) x 1/14). In 2012 through 2017, you can deduct $286 (($12,000 - $10,000) x 1/7), and in 2018, you can write off the last $143. After you have recovered your entire reforestation costs, your timber basis will become zero. You make amortization election and report the amount on Form 4562 Part VI. Amortization election may only be made on a timely filed return (including extension) (Section (a)). However, for a timely filed return without making the election, the IRS allows the taxpayer to still make such election by filing amended return within 6 months of the due date of the return (excluding extension). Write "Filed pursuant to Section " on Form Attach a statement to your tax return giving the purpose, nature, and amount of the expenditures and the date, location, and type of timber being grown (see the instructions for Form T (Timber), Forest Activities Schedule). For timber held as investment property, report the reforestation deduction in the front page of Form 1040 by writing reforestation and the amount in the "Adjusted Gross Income" section. For timber held as business property, report the reforestation amount under Other Expenses on Form 1040 Schedule C. Form T (Timber), Forest Activities Schedule Part IV should be filled out as part of the record if not required to file (see page 24). Note: Reforestation expensing and amortization can be deducted even if you do not take itemized deduction. 14

20 III. CAPITAL ASSET AND COST RECOVERY 3. TIMBER DEPLETION DEDUCTION Depletion refers to the cutting of standing timber. Depletion Unit = Adjusted Basis / Total Timber Volume The depletion unit is usually measured in dollars per unit of timber, such as tons, thousand board feet, or cords (or per individual tree for Christmas trees). Depletion Deduction = Depletion Unit x Timber Volume Harvested Depletion allows owners to recover timber basis at the time of timber sale. The amount of depletion is subtracted from the timber sale proceeds in computing the taxable gain or loss. Depletion deductions are allowed to the owner of an economic interest in standing timber (Section (b)). The timber owners look for the return of capital invested. You had a timber sale in 2011 in which 1,000 cords of pulpwood was sold at a lump sum of $15,000 ($15/cord). The total amount of timber on your property was 3,000 cords, with an adjusted basis of $6,000. Your selling expense was $1,000 for a consulting forester. Your timber depletion unit is $2/cord ($6,000 / 3,000 cords). Your depletion deduction for the sale was $2,000 ($2 x 1,000 cords sold). The taxable gain was thus $12,000 ($15,000 - $2,000 depletion - $1,000 expense). It's prudent to file Form T Parts II and III when a depletion deduction is claimed. The depletion deduction is reported in the year the timber is sold. It's prudent to file Form T (Timber), Forest Activities Schedule, with your tax return to claim the depletion deduction (see page 24). You calculate the depletion deduction using Part II of Form T. You must retain adequate records to substantiate your timber basis and the timber depletion deduction. 15

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